What Does Budget Mean for U.K. Pound?

Many people are probably wondering what Britain’s most important and painful budget in decades will mean for the U.K. pound. Well, don’t ask analysts in the foreign-exchange market, because their predictions are all over the map. But here’s a sample of what they’re saying and why.

First, some stage-setting. At 12:30 p.m. in London, U.K. Treasury chief George Osborne will likely announce major spending cuts and tax increases in an effort to close Britain’s double-digit budget deficit, which will be the biggest in the 27-member European Union this year, according to the European Commission. Mr. Osborne fears that with a debt crisis roiling Europe, Britain will be vulnerable if it doesn’t do enough to fix its finances and win the confidence of credit-ratings agencies.

All three major agencies – Moody’s, Standard & Poor’s and Fitch Ratings – will be watching today’s events carefully, but only Standard & Poor’s is actually reviewing Britain’s triple-A rating for a possible downgrade, which would spook global markets. The rating “outlooks” from Moody’s and Fitch are still “stable” despite their saber-rattling warnings to Britain.

The danger, however, is that severe austerity measures will drain Britain’s economy of much-needed energy, possibly even risking a dip back into the recession the U.K. just emerged from. U.S. President Barack Obama has already warned global leaders that they should still focus on economic recovery rather than withdrawing stimulus efforts.

Mr. Osborne’s challenge, then, is to please the credit raters without seriously harming Britain’s economy. The broad outlines of his plans for an austere Britain will arrive today, but many of the nitty-gritty details will wait until a spending review in the autumn.

So where does this leave sterling?

So far today, sterling is suffering a little, falling 0.2% to $1.4728. It may take a while for currency investors to actually digest the details of today’s pronouncements, which will cover everything from a new bank tax and postponed government projects to increases in alcohol duties, capital-gains tax and sales tax along with updated financial forecasts. But here’s what could happen.

Scenario 1: Most investors already expect a severe set of austerity measures and believe Mr. Osborne will do what it takes to deal with the deficit. Here’s proof: Sterling has risen to $1.47 from $1.43 in mid-May. What investors aren’t sure about, however, is what the credit-ratings agencies will do. If and when the agencies give a green-light to Britain, sterling could rally. “We don’t expect the agencies to slash the U.K.’s sovereign rating and we do look for the pound to rise as a result,” said Steve Barrow, a currency analyst at Standard Bank in London in a recent report. “We feel that ratings agencies will be suitably impressed.”

Analysts at Royal Bank of Scotland are slightly more bullish; they figure that just the fiscal belt-tightening could nudge sterling higher. And it’s not unreasonable to be bullish on Britain: Despite all the doom and gloom in financial markets, the U.K. economy has been showing strong signs of a recovery in recent months. Expect to be pleasantly surprised by Britain’s second-quarter GDP reading.

Scenario 2: It’s possible that there’s no oomph left in the sterling rally. In that case, the currency may just trade sideways after bouncing around today. Analysts at Italian bank UniCredit say “a tough U.K. emergency budget will not necessarily help sterling, as this may already be fairly priced in.” They don’t see sterling passing the $1.49/$1.50 level.

Scenario 3: Sterling drifts lower as investors take stock of how the Osborne budget will affect Britain’s economy. Heavy fiscal consolidation poses risks to the economy, which means the U.K.’s central bank may keep its benchmark short-term interest rate lower for longer. That, in turn, will make sterling less attractive by putting a lid on investment returns. “While this is good news for debt sustainability, heavy fiscal consolidation one year earlier than the G-20 prescription … will weigh heavily on activity and keep monetary policy super loose for longer,” says Chris Turner, a currency analyst at Dutch bank ING in London. “We cannot see how this is good news.” He sees the pound sliding back to $1.46.

And finally, Scenario 4: Mr. Osborne could overshoot in his budget-cutting gusto, sparking further speculation that Britain will experience a so-called “double-dip” recession. This seems unlikely for now, but it would hammer sterling. Recent research published by the National Institute for Social and Economic Research suggests Mr. Osborne’s fiscal plans may hurt Britain’s GDP now but much of the impact will be only temporary, leaving room for the economy to improve later on.

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